The government is likely to overshoot the FY12 budget deficit target of four per cent of GDP, with estimates indicating that it will be higher, at five per cent or more if revenue measures fail to yield desired results. This is a real possibility, especially if inflation declines in line with SBP forecasts, as 70 per cent of all taxes collected are ad valorem taxes on the consumption of goods and services. This indicates that the government’s borrowing needs will be higher than projected in the budget. Financing this large deficit will remain a challenge, especially with the $11.3b IMF loan suspended and the privatisation program stalled, said economist Sayem Ali. He further stated in the Global Research report of Standard Chartered, released on 15th of this month, that domestic sources of financing will shrink as banks shift lending to the private sector, and there is a risk that the government will revert to printing money once again to fund its large deficit, fuelling higher inflation. The main cause of concern for markets is the sharp build-up of debt and the government’s inability to meet its budget targets. The SBP stated that the FY11 deficit was significantly higher at 6.2 per cent of GDP, compared with the FY11 budget target of 4.7 per cent of GDP and preliminary estimates of 5.7 per cent of GDP presented in the FY12 budget.
In a surprise move, the State Bank of Pakistan (SBP) cut policy rates by 50bps at the July 30 meeting, with overnight deposit and lending rates cut to 10.5 per cent and 13.5 per cent, respectively. The central bank expressed concern over the sharp decline in investment spending, which declined to 13.4 per cent in FY11 (ended June 2011) – the lowest levels since 1974 – leading to a marked slowdown in growth to 2.4 per cent in FY11, from 3.9 per cent in FY10. This marks a significant shift in monetary policy focus, which has remained hawkish in response to high inflation and expansionary fiscal policy over the last two years, Sayem added. The SBP expects growth to pick up to 4.2 per cent in FY12, from 2.4 per cent in FY11. Growth slowed sharply in FY11 to 2.4 per cent, down from 3.9 per cent in FY10, primarily due to damage caused by floods last summer. However, the central bank voiced concerns over the sharp decline in investment spending over the last four years, raising concerns over the economy’s ability to meet rising demand and sustain growth over the medium term. Investment spending declined sharply to 13.4 per cent of GDP in FY11, down from 22.1 per cent of GDP in FY08 and the lowest level since 1974.
The central bank projects inflation to average 12 per cent in FY12, down from 13.9 per cent in FY11. This indicates that further rate cuts are likely in H2 if inflation does decline in line with SBP projections. Inflation should decline going forward on a reduction in money printed by the government and the build-up of FX reserves to record high levels of $18.2b. The central bank is also eyeing a decline in headline inflation in H2-2011 due to the base effect of high inflation last year due to floods. The recent decline in international commodity prices should also help to bring down inflation.
The key anchor of inflation expectations has been the strong build-up of FX reserves to $18.2b (6.7 months of import cover) by June 2011, from $16.7b in June 2010. Sharp Pakistani rupee (Rs) depreciation over the last three years has been a key inflation driver. The build-up of FX reserves on the back of record exports and remittances has helped stabilising the rupee, ending FY11 at 85.9 against the US dollar, down from 86.25 at end-September 2010. However, the rupee’s downtrend has resumed in H2-2011 on a widening trade deficit and large external debt payments. During July to August 2011, the trade deficit widened to $3.3b, from $2.8b in the same period last year. Pakistan also has large external debt payments of $4.2b in FY12 compared with $3.5b in FY11, including $1.4b of repayments to the IMF. The central bank projects a current account deficit of $2b (0.5 per cent of GDP) in FY12, compared with a surplus of $542mn (0.3 per cent of GDP). This indicates further pressure on FX reserves and, in our view, Sayem said, USD/PKR will depreciate a further three per cent in the current fiscal year.
The current account posted a surplus of $542mn (0.3 per cent of GDP) in FY11, versus a deficit of $3.9b (2.2 per cent of GDP) in FY10, led by record exports and remittances. Exports posted impressive growth of 29.4 per cent in FY11, rising to $25.5b, from $19.6b in FY10. Higher cotton prices, higher wheat exports and reconstruction activity in Afghanistan all contributed to strong export growth. Remittances surged to a record $11.2b (5.3 per cent of GDP) in FY11, up 26 per cent from $8.9b (five per cent of GDP) in FY10. This is attributed to the regulators successfully bringing in more remittances through the banking channels by reducing the spreads between the interbank and open market FX rates, and through a real-time transfer platform that allows remittances to be instantly credited to clients’ accounts. The strong growth in remittances has helped strengthen the FX reserve position.
The main cause of concern for markets is the sharp build-up of debt and the government’s inability to meet its budget targets. The SBP stated that the FY11 deficit was significantly higher at 6.2 per cent of GDP, compared with the FY11 budget target of 4.7 per cent of GDP and preliminary estimates of 5.7 per cent of GDP presented in the FY12 budget. The government is likely to overshoot the FY12 budget target of four per cent of GDP, with estimates indicating that the deficit will be higher, at five per cent or more of GDP if revenue measures fail to yield the desired results. This is a real possibility, especially if inflation declines in line with SBP forecasts, as 70 per cent of all taxes collected are ad valorem taxes on the consumption of goods and services. This indicates that the government’s borrowing needs will be higher than currently projected in the budget. Financing this large deficit will remain a challenge, especially with the $11.3b IMF loan suspended and the privatisation programme stalled. Domestic sources of financing will shrink as banks shift lending to the private sector. There is a risk that the government will revert to printing money once again to fund its large deficit, fuelling higher inflation.
The $11.3b IMF Stand-By Arrangement (SBA) comes to an end in September 2011. Disbursement of the remaining $3.8b of the IMF’s loan remains suspended due to delays in key tax and expenditure reforms, leading to a widening of the fiscal deficit and a sharp increase in debt. Public debt had increased to 62 per cent of GDP by March 2011, up from 61.4 per cent of GDP in June 2010. The FY12 budget measures will inspire little confidence; the government targets a deficit of four per cent of GDP, from an estimated 6.2 per cent in FY11. However, eliminating power subsidies and meeting the ambitious tax targets will not be easy. Debt sustainability remains a concern, as the IMF is unlikely to release more funds and time is running out. The government is already in talks with the IMF for a new loan. However, early indications are that the IMF will demand prior action on key reforms, including the elimination of subsidies and the introduction of new tax measures before releasing funds. The IMF has suspended disbursements since May 2010.
